Dividend policy determinants: an investigation of the influences of stakeholder theory

Financial Management (Financial Management Association), Autumn, 1998 by Mark E. Holder, Frederick W. Langrehr, J. Lawrence Hexter

There is considerable debate on how dividend policy affects firm value. Some researchers believe that dividends increase shareholder wealth (Gordon, 1959), others believe that dividends are irrelevant (Miller and Scholes, 1978), and still others believe that dividends decrease shareholder wealth (Litzenberger and Ramaswamy, 1979). Financial management research on financing policy decisions, including the dividend decision, considers investment as an exogenous variable, or at least as having a fixed, known distribution.

However, recent research (Cornell and Shapiro, 1987; Peterson and Benesh, 1983; Prezas, 1988; and Ravid, 1988) suggests that there are interactions between investment and financing decisions. Cornell and Shapiro (1987) posit that non-investor stakeholders (customers, employees, suppliers, distributors, and other firms providing complementary goods and services) influence this interaction of investment and financing decisions.

We investigate the influence of these stakeholders on firms' dividend policy by examining the interaction between the dividend and investment policies. We propose that both non-investor stakeholders and capital suppliers have an impact on a firm's dividend policy. To test this proposition, we use a more direct measure of free cash flow as a way to relate dividends and agency costs and an objective smoothing procedure on the dividend-payout ratios. Our results indicate that an interaction between the dividend and investment policies of a firm does exist.

This paper is divided into five parts. In Section I, we review the related literature and provide background information on stakeholder theory and dividend policy. In Section II, we discuss our empirical model, followed by a sample description in Section III. We report our empirical results in Section IV. The final section discusses the implications of our results and provides concluding remarks.

I. Background

One group of financial theorists (Martin, Petty, Keown, and Scott, 1991; Miller, 1986; and Miller and Modigliani, 1961) provides a hypothesis for dividend policy irrelevance. This group bases its theory on the assumptions of 1) perfect capital markets, meaning no taxes or transaction costs exist, the market price cannot be influenced by a single buyer or seller, and there is costless access to information; 2) rational behavior on the part of participants in the market, valuing securities based on the discounted value of future cash flows accruing to investors; 3) certainty about the investment policy of the firm and complete knowledge of these cash flows; and 4) managers that act as perfect agents of the shareholders. For dividend policy to matter, one or more of these assumptions cannot hold.

One critical assumption that may not hold is certainty about the investment policy of the firm. Titman (1984) develops a model that hypothesizes a possible interaction between investment and financing decisions. His model suggests that equity holders have incentives to maximize the wealth of non-investor stakeholders in a firm. These stakeholders suffer costs in the event the firm liquidates. Their costs can take the form of job search costs by employees, increased maintenance costs for customers, or retooling costs for suppliers.

The firm may also bear some costs of uncertainty. Its customers may believe they will bear liquidation costs if the firm goes out of business, and they will discount the price they are willing to pay for its goods and services to reflect these anticipated costs. Customers can thus use capital structure as one indicator of the future default potential of their vendors.

Stakeholder theory, developed by Cornell and Shapiro (1987), complements the work of Titman (1984) by looking at the implicit claims on the firm. It is the implicit claims aspect of Cornell and Shapiro's stakeholder theory that creates the link between the investment and financing decisions of the firm, because the level of net operating income of the firm can be affected by financing decisions, such as dividend-payout ratios.

One of the key factors in their stakeholder theory is differentiating between explicit and implicit claims on the firm. Explicit claims are characterized as product warranties, price contracts, and wage contracts - in other words, legal contracts. Implicit claims are characterized as being too state-contingent or too ambiguous to reduce to a written or other explicit form. Some examples are the ability to provide service and parts, employment for people without contracts, and continuing sources of supply that do not require new negotiations.

The interests of non-investor stakeholders can affect the financial decision-making process of firms, through both explicit and implicit claims on the value of the firm (Jensen, 1983). The value of implicit claims is related to the total risk of the firm. As the firm decreases its ability to honor implicit claims, it becomes riskier to its stakeholders. As noted above, to compensate for this risk, the value of the goods or services that the firm sells is reduced. Implicit claims are more sensitive to changes in the financial condition of the firm than are explicit claims, since a firm can choose to default on its implicit claims without being forced into bankruptcy. If firms have serious cash flow shortages, they will default on implicit claims first, then on explicit claims. Thus, implicit claimants are at the greatest risk.